What is crowdfunding?

Crowdfunding is a new fundraising alternative that marries social media and finance. With crowdfunding, entrepreneurs reach out to the “crowd”—including their friends, customers, neighbors, supporters and social network—for funding. The idea is that lots of smaller sums of money can take the place of one or two large investors or patrons, and that technology can help streamline the process.

What is Regulation Crowdfunding and what changed on May 16th?

Crowdfunding is the final piece to go into effect of the JOBS Act—the landmark securities legislation that was passed in April 2012 to ease capital-raising for small businesses. Also known as Title III, it allows any American to invest in private companies that raise money through SEC-sanctioned crowdfunding portals or broker-dealers.

Before the JOBS Act and in particular Regulation Crowdfunding, it was difficult for most people (or at least the 95% of Americans who are not considered wealthy, or “accredited” investors) to invest in companies that were not publicly traded on the stock market.

What are the other parts of the JOBS Act?

Title I – Reopening American Capital Markets to Emerging Growth Companies:  Created a new category of issuers with less than $1billion in revenues that are subject to lesser requirements for going public.

Title II – Access to Capital for Job Creators (“accredited investor” crowdfunding):  Allowed private companies conducting a private placement under Regulation D Rule 506 to publicly market the offering as long as they only sell to wealthy investors. Also allows them to “test the waters.”[/showhide]

Title III – The Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012 (aka the ‘CROWDFUND Act’):  Allowed small businesses to market and sell securities to any investor, regardless of wealth.

Title IV – Small Company Capital Formation (aka Regulation A+):  Revised the existing regulation A by increasing the amount companies can raise to $50 million from $5 million and creating two offering tiers.

Title V – Private Company Flexibility and Growth:  Raised the number of shareholders a company can have before it is considered publicly held from the current 500-shareholder threshold to 2,000 shareholders

Title VI – Capital Expansion:  Helps small banks raise capital without triggering securities regulations. For more information on the JOBS Act, see our recent report here.

Wait, why did we need a special law to make it possible for people to invest in small companies?

I thought you might ask that! Before the JOBS Act, it was effectively illegal for average Americans to invest in private companies (with just a few exceptions). It all started in the 1930s, when the Securities Acts of 1933 and 1934 were passed in the wake of the Great Depression and stock market crash. The laws basically said this: if you are wealthy, you can invest in anything you want—private companies, real estate deals, whatever. But if you were not wealthy—that is to say, 95% of the population—then you were pretty much relegated to publicly traded companies.

The intention was to protect individual investors from snake oil salesmen peddling fishy deals. Publicly traded companies were (and still are) required to register with the SEC and disclose comprehensive financial information on a regular basis, so the logic was that, with public companies, investors would be armed with the information they needed to make an informed decision and avoid scams.

That worked fine for several decades, but things have changed. While information was scarce in the 1930s, it is widely available today, thanks to the Internet. And few people actually read those jargon-strewn quarterly reports and filings published by public companies, making them not that useful.

At the same time, the cost of going public has soared, putting it out of reach of all but the largest companies. And regulators were worried that small businesses and startups—weren’t being well served by banks and venture capital.

Over the years, lawmakers had carved out exemptions to the rules, namely Regulation D, Regulation A and Rule 147 (also known as the intrastate exemption) that allow unaccredited investors to invest in certain deals. But these exemptions still required a fair amount of costly legal and accounting work. The one time it’s absolutely okay and easy for private companies to get funding from regular (non-wealthy) investors is when they have a substantial, pre-existing relationship with those people—in other words, friends and family. But that can be a bit of a gray area, especially in the age of social media. And not everyone has a rich aunt.

The motivation behind the JOBS Act was to update our 80-year old securities laws for the Internet age and make it easier for smaller companies to raise capital. Under Title IV (the revised version of Regulation A) and Title III (Regulation Crowdfunding), of the JOBS Act, private companies are now allowed to reach out to the general public for funding.

How does this differ from Kickstarter or Indiegogo?

Kickstarter and Indiegogo are examples of what’s known as rewards-based crowdfunding—you contribute money to a project you want to support and, if all goes well, you get the product your money helped to produce or some other “reward.”(For example, if you funded a music project it might be a CD, or for a generous contribution, a backstage pass to a concert).

In contrast, with Regulation Crowdfunding, you are investing in a company with the promise of a potential financial return (or loss!)

I sometimes see this referred to as “equity crowdfunding. ” Does that mean companies only offer shares of stock?

No. Any security can be offered. That could take the form of an interest-bearing loan, convertible notes or revenue sharing agreements, as well as equity shares in the company.

How much can companies raise under Regulation Crowdfunding?

Up to $1 million in a 12-month period.

How much will it cost me to raise money for my company under Regulation Crowdfunding?

It varies, but it’s not cheap. Funding platforms are charging between 3% to 9% of the capital being raised. There may also be processing and other fees. Some sites, such as SeedInvest, charge a mix of 5% cash and 5% equity, based on the value of the raise. You also need to take into account legal and compliance costs, accounting costs, and any marketing expenses associated with the raise. The good news is that new technology solutions are expected to bring down the cost of raising capital through crowdfunding.

How much can I invest under Regulation Crowdfunding?

That depends. Individuals with annual income under $100,000 are limited to investing the greater of $2,000 or 5% of their net worth. Those with annual income of at least $100,000 are capped at 10% of their annual income or net worth, whichever is lower, subject to a total limit of $100,000. Check out this  calculator if you’re unsure.

What are the risks?

Investing always involves risk, and that is even more true with startups and small businesses. When it comes to crowdfunding, experts advise not investing more than you can afford to lose. (To reinforce that, the SEC imposed caps on how much individuals can invest – see above).

What if I change my mind?

Investors have up to 48 hours prior to the end of the offer period to change your mind and cancel your investment commitment for any reason.  Once the offering period is within 48 hours of ending, you will not be able to cancel. The one exception is if the company makes a material change to the offering terms or other information disclosed to you, in which case you’ll be given five business days to reconfirm your investment commitment.

How do I make a crowdfunding investment?

You can only invest in a crowdfunding offering through an online funding platform, or intermediary. Intermediaries may be a broker-dealer or a more lightly regulated funding portal, but they must be registered with the SEC and be a member of the Financial Industry Regulatory Authority (FINRA). You can obtain information about a broker by visiting FINRA’s BrokerCheck or calling FINRA’s toll-free BrokerCheck hotline at (800) 289-9999. You can obtain information about a funding portal by visiting the SEC’s EDGAR website.

For more information, see this investor bulletin from the SEC.